There’s no shortage of talk about the dire budgetary straits that state governments are in these days and even some talk of states declaring bankruptcy:
Imagine a time a year or two into the future. A large American state has reached the limit of its ability to raise taxes and cut spending. It then is unable to roll over its debt. It defaults.
Imagine also that a hedge fund has bought a good deal of that debt in the distressed debt markets. It puts all that debt in a newly formed limited liability company, or L.L.C., and when the state in question defaults on the debt, the L.L.C. files a Chapter 11 petition.
And then the debtor (the L.L.C.) seeks to enforce that debt, as it is the only asset in the debtor’s bankruptcy estate.
“Impossible!†you say, since states enjoy sovereign immunity. Well, outside of bankruptcy they do. But in 2006, the Supreme Court held that the Bankruptcy Clause to the Constitution represents an exception to the normal rule of sovereign immunity. So maybe this little scheme might work, at least if the L.L.C. were given a few other assets to make the scheme a little less obvious.
There is one teeny, weeny little problem with this: the federal courts have exclusive jurisidiction over bankruptcy and there are no provisions under the federal code for a state declaring bankruptcy. Municipalities specifically have the ability to declare bankruptcy (if authorized by their states) but there is no mention of states and it seems to me that a federal judge would be far more likely to take other actions, e.g. forcing a state to raise taxes under mandamus, than he or she would to allow a state to go through bankruptcy proceedings.
In my view it would be extremely imprudent to extend bankruptcy to the states. The current system provides a sort of subsidy to a state’s bonds in the form of confidence that the state won’t simply abrogate its debt. Were bankruptcy to be extended to the states would it provoke a loss of confidence in state bonds? That doesn’t seem like a good thing to me.
Why would a state even need to declare bankruptcy? Can’t they just default on some obligations?
Bankruptcy is protection from creditors, but it seems states have sufficient power to not need that sort of protection.
(Maybe some commentators are saying bankruptcy when they mean general, or broad, default.)
Note: I’m not suggesting default. I have some, but hopefully not too many, muni bonds myself. I want to get paid.
It just seems that unless things get better, some fraction of the bonds in my funds could suffer … perhaps a suspension of payment, something along the lines of what Orange County California did in its default, and then recovery.
Bankruptcy is protection from creditors, that is correct.
However, bankruptcy does not always mean stiffing creditors. Often times it means creating the means for the orderly resolution of debts. That is what Chapter 13, Chapter 11, Chapter 12 (for family farms), and Chapter 9 (for cities) is all about.
So, the idea of a state filing bankruptcy isn’t that absurd.
There’s just one problem I see. States are generally recognized as sovereign entities in their own right, albeit lesser sovereigns than the Federal Government. Subjecting them to the jurisdiction of a Bankruptcy Judge would probably require a Constitutional Amendment
I can’t see that any state would “stiff” creditors. They are dependent on bond issuance. What OC did (with bankruptcy) was suspend payment on bonds, with a promise to get things going again. They ended up paying and making up lost interest, in order to preserve their future borrowing ability.
Whatever states do, they must preserve the trust of the bond markets. Bankruptcy, and courts, are not necessary to insure that insure that.
Contrast to the little-guy bankruptee who can sneak off to make new income, “stiffing” old creditors. Hard for a state to sneak off.
Which is why the goal of bankruptcy would be to provide an orderly process for resolution of debts, which may include extending the maturity of bonds or other such measures.
And this isn’t necessarily a bad thing for creditors.
Musings.
Dave observes: “In my view it would be extremely imprudent to extend bankruptcy to the states. The current system provides a sort of subsidy to a state’s bonds in the form of confidence that the state won’t simply abrogate its debt. Were bankruptcy to be extended to the states would it provoke a loss of confidence in state bonds?”
I’m not so sure. Credit analysts no doubt consider both non-bankruptcy (“workout”) and bankruptcy options in evaluating state finances. Yes, and just as in a private setting, the specter of bankruptcy and its implications may provide comfort that the workout route will be taken, but there is little surety these days.
Doug observes: correctly, in my view, that bankruptcy allows for an orderly process. That’s the whole point. And that step 1 would be workout 101: extend maturities and price up the securities. But for how long? That’s always the question.
jp: is sanguine. For what reason I do not know. The whole hypothesis in Dave’s citation is that taxing and spending cuts have reached their limit. Cash flow is cash flow. So “..states have sufficient power to not need that sort of protection.” Seems odd. And: “Whatever states do, they must preserve the trust of the bond markets.” Misses the whole point; we are reaching the end game.
So Drew will observe, being a veteran of the workout wars, that creditors are going to look at the political (managerial) will to do what is necessary, with all due consideration of the desire to avoid bankruptcy and its costs, I’m not optimistic. States like CA, MI and, alas, IL seem politically incapable of fiscal responsibility. I would note all are controlled and enraptured by Democrat pie in the sky promises.
Creditors are not stupid, they will eventually evaluate cash flow in the context of political realities and actions and pull the plug, bankrupcy laws or no. The real debate, it seems to me, will come when the SD’s and TX’s of the world are asked to bail out the CA’s and IL’s.
Now THAT will be entertaining.
From this blurb, it doesn’t sound like the writer is talking about the state filing bankruptcy. There are some weird situations under Section 363(f) of the Bankruptcy Code where third party disputes get brought into the bankruptcy. For instance, if the hedge fund loaned the money to the state with a security interest in the buildings and other property owned by the state, the bankruptcy court could theoretically require the sale of state buildings and to the extent there are other entities that have potential claims on the buildings, their claims could be brought into the bankruptcy proceeding to resolved. At some point resolving and valuing competing claims against state property could appear to be an indirect bankruptcy proceeding.
But I think the problems with the scenario are twofold: (1) public lenders don’t get security interests in public property and (2) sovereign immunity.
OTOH, if a state files bankruptcy, I think the state waives any sovereign immunity; the primary problem is that the bankruptcy court does not have jurisdiction over states, someone would need to amend the Code.
I would like to see otherwise, but I predict that, at worst, some states default on payment to some bonds, and at that point the Federales just admit they’ve got to make loans to states and float national bonds to cover.
Actually, it is very like the Irish and German situation, isn’t it?
An article which I consider supporting:
http://www.calculatedriskblog.com/2010/12/bond-girl-default-and-bankruptcy-in.html
There are some major differences the most notable of which is that by and large it’s the largest, richest states that are in the deepest trouble. Additionally, divorce isn’t an option as it is in the case of the EU.
Yes, it is true that California is still wealthy. I suppose a significant portion of Federal income comes from here as well.
One thing about extending municipal bankruptcy to states is that municipal bankruptcies are fairly limited in scope. Municipalities are divisions of the state, so federal bankruptcy law is already limited by restraints on states rights. I don’t think a municipality can involuntarily be brought into bankruptcy or be compelled once in bankruptcy to auction off property. It’s more a vehicle for the municipality to obtain court supervision for putting together a plan to pay-off it’s debts.
I think such a plan, which showed how the state was going to get from point A to point B would be received favorably by lenders, even if past creditors had their interest rates reduced to market rates or payments extended out. If the plan is delay and use of underpants gnomes, it’s not worth the bother.
More musings:
I appreciate the erudite commentary on bankruptcy law, and Constitutional issues, but……..
1. From a creditor’s point of view, “wealth” is certainly nice. (Call it “collateral.”) But when any entity cannot reconcile its revenue and debt service realities, and resorts to asset sales, the end is approaching. Here in IL we sold off the toll road, and the parking meter business. No one will ever convince me that Mayor Daley is not “retiring” other than that he knows the jig is up, and he does not want to be the undertaker. Beware: Using “wealth” to support inadequate debt service capability is a short lived solution.
2. “I think such a plan, which showed how the state was going to get from point A to point B would be received favorably by lenders, even if past creditors had their interest rates reduced to market rates or payments extended out.”
Oh, my. I hope I’m interpreting this incorrectly. The notion that “fresh money” creditors would look favorably on a principal extension and interest rate reduction for “old money” creditors stuns me. Only if new money has a preferential payment to old money. Otherwise, what is to keep the new money from being stuffed?
Its a real conundrum, and the point I’m really making: If new money is subordinate, the cost of capital would be astronomical. If old money is stuffed, yet political realities still pertain, then the notion of new money is a pipe dream.
The thread has seemed to lose the initial postulate in Dave’s post: tax increases and spending reductions have maxed. What? No one wants to deal with Grecian, Irish, British………or Californian riots by overpayed and underworked public employees?
Interesting how often the less-indebted states are net recipients of federal tax money. IIRC Texas and SD are both net tax recipients in most years while California and Illinois carry the load.
Maybe we should equalize that a bit so that each state gets back what it pays in. Then, once they are deprived of my California dollars, and the Dakotas, Wyoming, Nebraska and other essentially unpopulated red states finish emptying out, we can sell them off to the Chinese.
Sorry, that was an unfair knock on TX: they usually break-even or are slight net contributors.
“The thread has seemed to lose the initial postulate in Dave’s post: tax increases and spending reductions have maxed.”
Only in the sense that shoes remain to drop.
Nice try, Michael. But your comment exposes Big Government for what it is: a big poker game. Everyone sends their money into the pot (Washington) and then we elect our poker players, er, Senators and Representatives, who try to outwit everyone elses poker players, er, Senators and Representatives, to see who can beggar thy neighbor the best.
Government as the local gambling establishment. Apropos. And they regulate OTB!!!! Sheish!
Drew:
That’s actually a great analogy.
Of course the pseudo-states — the mountain west and much of New England — have a disproportionate number of players in the game. The people in California have only the same number of Senators as the echoing void that is Wyoming. We ante up a hell of a lot more both collectively and individually.
Drew, my point was rather this (although I’ll make it more starkly here):
If California “stiffs” it’s creditors, but puts forward a plan that shows positive cash flow in a few years, California won’t have a problem on financing. You (if this were your task) would put money into a credible plan for the future.
I think stiffing is an exaggeration, when technically a default occurs when the terms of lending aren’t met, creditors will always claim they are being stiffed. Someone loaning to a state is taking substantial risk of uncollectibility, and if their payout is reduced to some sort of market valuation they should count their lucky stars in this environment.
To perhaps state it another way: I think Drew and I agree that G.M.’s creditors got screwed. If G.M. had gone through a bankruptcy in which the company emerged stronger and more profitable than before, I think creditors, even those that got screwed would invest, with a potential and very, very slight discount.
Did I mention I like fantasies with my hypotheticals?
PD –
“If California “stiffs†it’s creditors, but puts forward a plan that shows positive cash flow in a few years, California won’t have a problem on financing.”
This, of course is the problem. Government’s cannot be trusted. Hell, private enterprises cannot be trusted. The difference is that workout in a private setting comes with loan covenants. Fresh money can, as an empirical fact, rely on them. Government? Whims of voters? Whims of sympathetic courts to government?
You’d never see my money in that deal. That’s fool’s gold.
“You (if this were your task) would put money into a credible plan for the future.”
The operative word is “credible.” See above.
“I think stiffing is an exaggeration, when technically a default occurs when the terms of lending aren’t met, creditors will always claim they are being stiffed.”
Not really. They just expect to get paid for the now evident risk adjusted return expected of a failed deal. Not surprising.
“Someone loaning to a state is taking substantial risk of uncollectibility, and if their payout is reduced to some sort of market valuation they should count their lucky stars in this environment.”
No, they should admit they made a bad risk adjusted loan decision……….and move on, and not re-up. See my comment at the top.